Hercules Capital Inc (HTGC) 2015 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Hercules Technology Growth Capital Q3 2015 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session and instructions will follow at that time. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's conference, Michael Hara, Senior Director of Investor Relations. Please, go ahead, sir.

Thank you, Charlotte. And thank you, everyone. Good afternoon and welcome to Hercules' conference call for the third quarter of 2015. With us on the call today from Hercules are Manuel Henriquez, Founder, Chairman, and Chief Executive Officer, and Mark Harris, Chief Financial Officer.

Hercules' third quarter 2015 financial results were released just after today's market close and can be accessed on the Hercules' Investor Relations section at www.HTGC.com. We have arranged for a replay of the call at Hercules' webpage or by using the telephone number and pass code provided in today's release.

During the course of this call, we may make forward-looking statements based on current expectations. Actual financial results filed with the Securities and Exchange Commission may differ from those contained herein due to timing delays between the date of this release and in the confirmation and final audit results.

In addition, the statements contained in this release that are not purely historical are forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to uncertainties and other factors that could cause actual results to differ materially from those expressed in the forward-looking statements including, without limitation, the risks and uncertainties, including the uncertainties surrounding the current market turbulence and other factors we identify from time to time in our filings with the Securities and Exchange Commission.

Although we believe that the assumptions on which these forward-looking statements are based are reasonable, any of those assumptions can prove to be inaccurate and as a result the forward-looking statements based on those assumptions also can be incorrect. You should not place undue reliance on these forward-looking statements. The forward-looking statements contained in this release are made as of the date hereof and Hercules assumes no obligation to update the forward-looking statements or subsequent events. To obtain copies of related SEC filings, please visit SEC.gov or visit our website, HTGC.com.

For today's agenda, Manuel will begin the call with an overview of our Q3 2015 financial highlights followed by a business overview and an overview of the current market conditions and our perspective and outlook for Q4 and 2016. Mark will follow with a broader summary of our Q3 financial performance and results and following the conclusion of our prepared remarks, we will open up the call for Q&A.

With that, I will turn the call over to Manuel, Hercules' Chairman and Chief Executive Officer.

Thank you, Michael. And good afternoon, everyone. Welcome to the Hercules Technology Growth Capital Q3 2015 earnings call. Today I'm delighted to share with you that Hercules delivered another outstanding and impressive quarter, delivering net investment income of $0.33 per share and effective yields of 16.4%. Thanks to our outstanding and driven team of investment professionals who are executing exceptionally well on all fronts, the quarter exemplifies the achievement and the capabilities of Hercules by its results and its renewed origination commitment and the fundings that occurred during the quarter.

Our Q3 results serve to highlight Hercules' strong technology position within the market, market leadership position, as well as our continued unprecedented access to some of the leading, most innovative, and disrupting technology and life sciences companies, financially backed and supported by some of the industry's top tier venture capital firm. These outstanding and visionary venture capital firms are a tremendous source of deal flow to Hercules and we'd like to say thank you and acknowledge their continued trust and support and confidence in Hercules as a critical source of growth capital for the respective portfolio companies. Thank you very much for that continued support that is evidence with the deal flow that we witnessed in Q3.

In addition, Hercules' third quarter results demonstrate our high brand awareness, our market leadership position, and overall differentiation or quality that separate Hercules from the rest of the venture lenders. In addition, let's not forget one very important designation of differentiation within the BDC industry as well and that is that Hercules is an internally managed BDC meaning that we are directly aligned with shareholders and more interested in generating total returns on behalf of our shareholders than merely focused on the increasing AUMs for additional fees or asset management fees.

Now, with respect to Hercules' performance in Q3 and business and financial highlights. Q3 was an extremely busy and strong earnings performance quarter for Hercules on all fronts. If there was any doubt on our different coverage capability, I think that Q3 exemplified that capability with $0.33 in earnings on a $0.31 dividend. DNOI and NII were $0.36 and $0.33 respectively in the quarter, representing an increase for DNOI of approximately 33% and an increase for net investment income of 44%. This clearly was helped by the exceptionally strong early repayment activities that we witness in the quarter of nearly $190 million, representing a record for Hercules never achieved before with early prepayment activities taking place in one quarter.

On that, Hercules effective or realized yields, or effective yields during the quarter also increased to an impressive 16.4% marking a major step forward towards returning to our near-term historical effective yield levels of 14% and 16% as you witnessed we generated over the last eight to ten quarters trailing. Clearly increases in our effective yield above the core yields are directly impacted by increase in early loan repayment levels, generally occurring above the $60 million to $70 million level.

Why is that the case? Because typically Hercules tries to forecast and factor into some form of early repayment activities above and beyond the normal amortization of the portfolio. We typically tend to model anywhere between $40 million to $60 million and later $60 million to $70 million in the second half of any year.

As many of you may recall, we had been expecting and forecasting an increase in effective yields principally driven by our anticipated increase in early repayment activities to be taking place in the second half of 2015. Clearly that occurred. However, it occurred even sooner than we had anticipated since we were anticipating that early repayment activities to actually begin in the early fourth quarter and in fact began three weeks earlier than we anticipated in the third quarter.

Nonetheless, those effective yields were influenced by the increase in early payoff activities which allows us to also rebalance our portfolio and grow our portfolio in the areas that we'd like to as well as divesting ourselves from certain industries or exposure to geographic regions such as we did in Q3 with exposure to China, as an example.

That said, I'm very proud and would like to point to the fact that once again the Hercules investment team delivered an exceptional performance for the benefit of our shareholders. Our team was able to successfully originate and absorb almost all of the unexpected repayments of $190 million providing once again and similar to what we achieved in 2014, proving our access to unprecedented deal flow to help stem the onslaught of early repayment activities taking place and yet contain and materially reduce the reduction of the portfolio by a contraction that otherwise would've been fairly large with $190 million.

Further, Hercules' performance also amplified the industry leadership position and the origination platform that we have in place. For example, in Q3, typically our slowest quarter of the year but certainly not the case this year. In Q3, 2015, total commitments represented approximately $113 million. However, total new fundings during the quarter, a record level, represented $158 million of which $155 million of that was debt investment in new companies.

In addition during the third quarter, we continued to manage down our unfunded commitments. We work diligently during the quarter to begin the reduction of unfunded commitments as we indicated that we would do in our second quarter earnings call. I'm proud to announce today that we've seen a major accomplishment and achievement in that area. Unfounded commitments decrease from approximately $159 million in Q2 to $110 million in Q3 representing a 31% decline quarter over quarter.

Unfunded commitments related to milestones decreased even more impressively, declining from a $255 million level in Q2 to a mere $130 million in Q3, representing nearly 50% reduction in the unfunded commitment and once again proving that Hercules executive and do what it says and working diligently to reduce unfunded commitments as we indicated that we would.

As to achievement for the nine months ending September 30 on a year to date basis for Hercules, we originated over $630 million of total new commitments, putting us on pace to hit or exceed the record level of new commitments achieved in fiscal 2014. Equally as remarkable was Hercules' total new fundings during the quarter of approximately $532 million of which $518 million of that went into brand new debt investment activities on a year to date basis, putting us on pace to exceed all of 2014 record levels at the time of approximately $611 million of new fundings during that year. So far 2015 is shaping up to be an extremely strong year for Hercules and we are expecting an equally strong fourth quarter which I will talk to you and elaborate later on in my opening remarks.

At the end of the third quarter our total investment portfolio ended in approximately $1.2 billion representing a 16% increase over that of the year end 2014. And certainly putting us on pace to achieve our portfolio growth target of at $1.3 billion or greater. Of course that is subject to and contingent upon market conditions remaining favorable.

That said, despite and otherwise choppy and volatile stock market and concerns over Chinese growth rates and clearly uncertainty about the Fed's direction with interest rates, over the last few weeks and months, Hercules nonetheless continued to achieve a strong performance on executing on liquidity events during the quarter. We saw liquidity events in the quarter with two IPOs being completed in Q3.

On a year to date basis we've generated $8.4 million of realized gains for our shareholders, representing approximately $0.12 in future earnings that are distributed to our shareholders. I would like to remind our investors that Hercules still has approximately 130 unique and different positions in various privately funded life sciences technology companies that are progressing towards a M&A or IPO event sometime in their near future.

The $8.4 million of realized gains or $0.12 per share excluded any impact of realized gains that we still hold in bonds. We currently hold approximately unrealized gains in bonds of approximately $10 million to $11 million or representing anywhere between $0.12 to $0.14 per share. Based on last night's close at $3.17, Hercules currently holds approximately 1.4 million shares in bonds to date.

As we continue to originate new loans, especially new loans with warrants, you can expect us to continue to grow and add additional warrant position in our already growing and impressive warrant portfolio. As a reminder, this warrant portfolio serves as a backdrop for additional capital gains for Hercules to harvest on behalf of our shareholders and generate an incremental higher total return than the majority of the BDCs because of the ability for us to monetize those warrant positions that we have in various privately funded life sciences and technology companies.

However, I want to remind our shareholders that we do not expect all of our companies to mature and ever reach an IPO or M&A event. It would be nice if that's the case but clearly in that business that is not the expected outcome of all of our warrant positions. With the maturity of Hercules now approaching nearly 12 years since its founding and having many of our investments now begin to mature above the seven or eight years of maturity we can expect to see a normal cadence of realized warrant gains over the proceeding few fiscal years on the forward basis that we expect to see from warrant monetizations.

As to liquidity and exits so far realized this year, 15 portfolio companies have completed or announced IPO or M&A events so far this year. As I said a minute ago, two of those companies complete IPO events in Q3 alone, ViewRay and Neos. In addition to that, post-completion of Q3, we also saw two additional companies complete IPO events so far in Q4 Edge Therapeutics and Cerecor.

Unlike many who are trying to get IPO events, Hercules' portfolio of companies continues to execute and deliver nice liquidity outcomes with M&A and IPO events. We ended up the quarter with approximately four remaining companies in IPO registration. Originally as you'll see in our earnings lease, it's six but two of them went public in the first month of October in the fourth quarter leaving us a net four companies in IPO registration.

On the M&A front, equally as busy. Hercules saw two companies complete M&A events or announcements in Q3, Atrenta and Good Technology. Both completed or announced M&A events. Subsequent to quarter end, like we had in our IPO, we also had two additional companies announced pending IPO -- excuse me, pending M&A events such as Eccentex and Gazelle, that was recently announced as well that are expected to close here shortly.

We also have an additional four companies who made us aware of actively engaged M&A discussion but as always I want to caution everyone as I've seen over the years many, many M&A events fall apart at the last minute and never get completed. We remain hopeful that our four pending M&A events that we're aware of will complete and close in Q4 which would be another positive and accretive event on behalf of our shareholders.

We're extremely well positioned entering Q4 2015 with an exceptionally strong balance sheet, having additional leverage capacity available coupled with an ample amount of liquidity on our balance sheet. Thanks in no small part to the early repayment activities we are able to recycle those early repayment activities into available dry powder or liquidity representing nearly $300 million of dry powder in order to grow our portfolio and continue to generate additional interest income and earnings growth for our shareholders.

Although it was a painful process we would like to thank the SEC for their hard work during the third quarter, working diligently with Hercules and its legal staff in finding a resolution that I'm sure other BDCs were equally as thankful for the SEC achieving this endpoint. We're very grateful to the SEC for finally reconciling and understanding the unfunded commitment phenomena that is associated specifically with venture lending and that of the broader BDC industry.

And with that, we were happy to be awarded the declaration of our shelf effective, allowing us to finally pursue the refinancing of our 2019 bond. I would like to assure investors that we are not, as someone has been advocating, we are not interested in raising equity at these levels. Despite some of the rumors I've heard since our shelf became effective, Hercules has no intent of raising equity at these current prices.

We do in fact intend to use our shelf to refinance our existing 7% bonds that are due to mature in 2019 and in fact just earlier this week we made an announcement in a press release and 8-K, announced the intent to redeem approximately $40 million of those 7% bonds that we expect to take place in mid- to late December. I expect the retirement of those bonds, as I'm sure you're aware of, to cause a onetime non-cash impact to earnings in Q4 2015 and then thereafter represent an accretion to our shareholders on increased earnings of approximately $0.01 per share per quarter in fiscal 2016 with the retirement of those $40 million in bonds.

Lastly, during the quarter it was also a very busy quarter where Hercules also received affirmation of its investor grade rating from both S&P and Kroll. We received a triple B minus from S&P and also from Kroll a triple B plus, once again reaffirming our investment grade rating to which we are grateful to in recognition of the hard work of our credit performance in managing of our credit loan book throughout the many years we have.

Finally, and being true to our word, Hercules commitment to execute a stock buy back program, if and when the stock approached levels where we were found to be undervalued. I'm happy to say in defense to our shareholders that we true to our words and Hercules committed and executed approximately $4.5 million of stock open market purchases, representing $4.5 million against our $50 million stock buy back program.

We stand ready and willing to reenter the market if and when our stock approaches levels near net asset value that we believe do not reflect the proper value of our company. We stand committed as an internally managed BDC to ensure that we look out for the best interest of our shareholders and continue to monetize the total return potential of our company and our stock on behalf of our shareholders.

Now let me quickly turn my attention to the venture capital industry which experienced a fairly vibrant activities. Fundraising, approximately 67 funds raised approximately $4.7 billion in Q3, an impressive number. However the year to date number is even more impressive. $18.7 billion was raised by the venture capitalists in the first three quarters of fiscal 2015 against the backdrop on the same period of 2014 of $15.5 billion.

Even more impressive, if not eye opening, was their new investment activities. The venture capitalists invested $19 billion in Q3, representing a 68% increase over the same period of 2014. Even more impressive was the year to date number. And even this one surprised me. On a year to date basis, the venture capitalists invested $54.6 billion through the first nine months of 2015 compared to only $39.5 billion for the same period of 2014. This is important because that is a source of refinancing for many of our companies and also allows us to see continued appreciation in our warrant portfolio.

As the business sectors or investment allocations, business and financial services also known as fin-tech has received the largest investments during the quarter of $5.3 billion. Consumer, which includes gaming and social media sites was the second recipient of capital at $5 billion. Hardware or investment information technology companies received $4 billion and healthcare continued to drop precipitously to approximately $3.7 billion in the quarter which we believe will represent a stabilization and outlook into healthcare and healthcare investing on a go forward basis.

IPOs as we all now know has dried fairly significantly. However we saw 12 companies complete IPOs that are venture backed in Q3. However, I'm very proud to point to the fact that two of the 12 companies that went public happen to be Hercules' companies, Cerecor and Edge Therapeutics. Those companies, those 12 companies, raised a total of $1.6 billion in the process. Yes, the IPO numbers have dropped precipitously, representing a 56% drop from Q2 but we actually think that's a bit distressed and we think we'll see some pick up in Q4.

M&A on the other hand, which typically is the case when IPOs tend to dry up, M&A on the other hand picked up the activities, having a robust quarter. We saw 127 companies complete M&A events representing $17 billion in value. This compares to 98 M&A events completed in Q2 '15, representing $12 billion or so. And finally, turning my attention to Q4 as well as beginning to lay out our strategy for 2016, as we look to 2016 we expect to actively continue to deploy our $300 million in liquidity that we have on our balance sheet.

With that, we can expect to see continuation of growth in earnings as we had forecasted in Q2 and that growth in earnings will continue in Q1 and Q2 2016 and beyond. We absolutely still expect to see coverage of our dividend absolutely by net investment income but even today I'm happy to report with early indications on our Q4 activities and what we saw in Q3 we now see and expect to see an earnings spillover in fiscal 2015 and 2016. Although I'm reluctant to show the amount at this point until the end of the year, we are now seeing the ability to see a spillover which means that any questions in dividend coverage should be off the table.

In addition, we're also keeping a very watchful eye on the M&A activities or M&A flirting activities going on in the BDC sector. We are certainly very interested to see consolidation in the BDC industry and remain very watchful for key developments that may transpire in the M&A sector within the BDCs themselves and we ourselves remain interested in potentially exploring M&A activities on some players that exist within the marketplace today. We're currently monitoring these developments very, very closely. We hope to see the first wave of consolidation begin and we will report back as those activities begin to take shape.

In the meantime, we are continuing to focus on our core business and our core activities. Our business has never been stronger. Our liquidity has never been better. And the continued execution of our investor professional team has never been stronger or better than I've seen in quite some time. I'm very proud of the execution of our team and also welcome and thank the venture capital community for acknowledging the Hercules capabilities.

It has become clear in the business that large balance sheets and large access to liquidity make you a stronger and better financial partner for many of the venture backed companies in the marketplace. Hercules is extremely well positioned to take advantage of that opportunity as others are struggling for liquidity or trading below book value. We have the luxury of having both liquidity and trading at a premium to book value thanks in no small part to our investors acknowledging the positioning that Hercules has in its marketplace today.

With that I'll turn the call over to Mark Harris. Mark?

Thank you, Manuel. What I'd like to do is try to give some context to the numbers that Manuel covered earlier in the conversation, starting off with net investment income which increased to $23.6 million in the third quarter versus $16.8 million in the second quarter, an increase of 41%. On a per share basis, NII increased to $0.33 per share compared to the $0.23 per share in the second quarter, another increase of 44%. We saw our return on average assets on a NII basis increase to 7.5% in the third quarter from 5.3% in the previous quarter with our return on average equity on a NII basis materially increase to 13.7% in the third quarter from 7.5% in the second quarter.

Investment income drove a lot of this which increased to $47.1 million in the third quarter of 2015 versus $37 million in the third quarter of 2014, an increase of 27% over the same period in the previous year. Our loan portfolio decreased on a cost basis to $1.109 billion in the third quarter compared to that of $1.171 billion in the second quarter or a decrease of approximately 5%.

As Manuel discussed, while we had new funding of approximately $157 million which was a record third quarter for Hercules, this was offset by the decrease related to the $190 million of unscheduled pay downs in the quarter which was not fully anticipated. The GAAP effected yields increased to 15.4% in the third quarter from 13.8% in the second quarter, an increase of 260 basis points. The increase is primarily related to the acceleration of interest and fees pertaining to early loan pay downs and payoffs. We expect our prepayment activity to return to a rate of $50 million to $70 million in the fourth quarter.

The weighted average age of our loan portfolio at the end of the third quarter is young given the velocity of prepayments we experienced in the third quarter. As such we would expect to see retention in our portfolio over the next couple of quarters, leading to loan growth in the fourth quarter and into 2016. Core yields which exclude the effect of fee accelerations that occurred from early payoffs and onetime events was 12.6% in the third quarter compared to 13.2% in the second quarter, a decrease again of approximately 5%.

However, in the second quarter we did have higher than average expired on funded commitments. Thereby, backing that out on a like for like basis we would've been flat in the two comparative periods. Interest and fee expenses decreased by 3% to $8.9 million in the third quarter compared to $9.2 million in the second quarter, a decrease of approximately $300,000.

We had interest and fee expense related to the redemption of our $20 million of redemptions of our 2019 7% notes of approximately $500,000 in the second quarter and this was offset by the increase of $200,000 in interest due to the draw down on our Wells Fargo facility which was outstanding for more of the quarter. This had a coupon rate of LIBOR plus 325 basis points. As we disclosed in our press release yesterday we intend to buy back $40 million of our 2019 7% notes and expect that to have a forward interest and fee savings of approximately $800,000 or $0.01 EPS accretion per quarter.

In the fourth quarter we anticipate a onetime non-cash charge of approximately $125,000 pertaining to this potential buyback. Future interest rate hikes and their impact to prime and LIBOR rates are accretive to Hercules. First, our outstanding leverage at the end of the third quarter is 100% fixed interest rate facilities.

Second, 98% of our loans are variable interest loans with floors. That's a 50 basis points increase in prime rates which most of our loan agreements are based on, would be accretive to interest income by approximately $4.4 million on an annualized basis or an increase of NII per share of $0.06. Our weighted average cost of debt reduced to 5.6% in the third quarter in 2015 from 6.1% in the second quarter of 2015, primarily due to the second quarter fees being higher because of the pay down of our 2019 7% notes related to the acceleration of fee expenses in that quarter.

Backing out accretion of non-cash fee expenses in the second quarter, our weighted average cost of debt would've been consistent with the third quarter of 5.6%. In an effort to reduce our weighted average cost of debt we would like to be sub-5%. We're exploring numerous alternatives in the market. As Manuel mentioned, with our effective shelf registration per our press release yesterday as well which was achieved through meaningful discussion with the SEC without limiting our ability to continue our business as previously conducted. This is opened up further options for us in the public debt markets.

Net interest margin increased to $38.2 million in the third quarter from $29 million in the second quarter for an increase of 32%. Net interest margin as a percentage of average yielding assets further improved to 13.4% in the third quarter compared to 10.2% in the second quarter. Much of this increase is due to the favorable impact of NII previously discussed.

Operating expenses, excluding interest and fees increased in the third quarter to $14.7 million from $12.2 million in the second quarter, an increase of 20%. This wasn't a surprise given that 20% increase in interest income and 41% increase in NII. G&A went up by 11%, mainly driven by continued growth of the company. Employee compensation increased 25% with much of this being around bonuses given our stellar performance for the first three quarters of the year followed by the increase in headcount.

We had unrealized appreciation on investments of $25.9 million in the third quarter compared to the depreciation of $12.8 million in the second quarter. While our loan portfolio had unrealized appreciation of $1.4 million we did have $27.3 million of unrealized depreciation pertaining to our equity in warrants. To put our equity in warrant depreciation into context, ignoring the conversion of unrealized gains to unrealized losses, the true depreciation was $22.3 million in the third quarter.

With 53% of our companies being public and 47% being private we had to do mark to market fair value accounting. Fair value from the beginning, equity and warrant balances was actually down 22%. However this is entirely consistent with the capital markets performance. The Russell 2000 Biotech index was down 24% in the same period and the Russell 2000 Technology index was down 11% in the same period. Both of those are up 12% and 11% from their quarter end position to today. So, the technology is actually rallied back and half of the biotech index is also rallied.

I turn my attention now over to the balance sheet. Overall our loan portfolio decreased to 87 companies in the third quarter from 96 companies at the end of the second, we added five new companies and funded ten of our existing portfolio in the third quarter but we also had 14 companies pay off their debts as well. The number of non-accrual loans increased by one from the previous quarter. Our non-accrual as a percentage of debt investment on a cost basis rose from 3.9% in the second quarter to 4.4% in the second quarter. However approximately half of this increase is related to the drop of our debt investment on a cost basis while the other half is related to the addition of the one company to the non-accrual bucket.

We would also further note that we have seen some improvements to the companies that have been in non-accrual before the third quarter and expect to see this come down from the current 4.4% non-accrual rate we are experiencing today.

We are very pleased that our now losses through inception which include equity and warrant gains decreased to $3.6 million which is an outstanding number given $5.6 billion of commitments we've had to date since inception or a loss of only 1 basis point on an annualized basis.

Liquidity went to $296.3 million in the third quarter from $215.4 million in the second quarter. Cash increased by $31.3 million and we also paid off our Wells Fargo facility of another $49.6 million. Our debt to equity ratio remains strong. Our regulatory leverage which excluding SBA as we have an exemptive relief from the SEC reduced to 55.4% at the end of September versus 60.5% at the end of June. Total leverage with the SBA reduced to 81.7% at the end of the third quarter versus 86% at the end of the second quarter. Based on our regulatory leverage ratio we have the ability to add another $322.7 million of debt without breaching our debt equity ratio requirements.

Our asset coverage ratio increased to 281% from 265% primarily from the payoff of the Wells Fargo facility in the third quarter. This is well above the required 200% coverage threshold. Net assets fell by $20.9 million to $722.8 million at the end of the third quarter. Our NAV per share fell to $10.02 versus $10.26 last quarter. This is primarily driven by the unrealized appreciation in our equity and warrants offset by our realized gains in the period as discussed previously.

Finally we're pleased to declare our 41st consecutive dividend of $0.31 per share that will be paid on November 23 as approved by our board of directors with the record date of November 16. Based on our current projections we expect our 2015 dividend to be covered through a combination of our operational performance and spillover that we have from 2014.

With this report I now return the call over to the Operator to begin our Q&A period.

(Operator Instructions) John Hecht, Jefferies.

Thanks very much. Active quarter for you guys. Just considering the repayments, the elevated repayments and the commentary that you expect these to come down in Q4, so you get back to portfolio growth, a couple questions. That is in the near-term, what drives unexpected repayment activity? What kind of visibility do you have into 4Q that you wouldn't experience that spike over the remaining part of the year?

John, thanks. Good question. As we've tried to share with investors over the ten years that I've been on these earnings calls is it's very difficult for us to have visibility a full quarter out. I almost like to say that we probably have visibility and confidence probably on a 45 or so rolling basis. And a lot of the take outs or early repayments are oftentimes driven by pending M&A events that may or may not take place or as we saw in the third quarter, by some commercial bank refinancing some of our loans.

Because it's a natural progression of our companies that while we're working with them, they're young and experiencing growth and eventually they will mature to a level that a commercial bank may offer some of the resources that we do not provide like deposits or operating accounts or what have you. But during the early stage of growth, it's an area where we actually work with our companies very diligently and work with them.

That said, in the third quarter we proactively took the approach of also reducing exposure in certain areas, i.e. China was one of the areas that we made a fairly strong push to reduce exposure in that area. So, we kind of helped a little bit of that portfolio turnover by encouraging some of these companies to seek financing elsewhere as we wanted to reduce our Chinese exposure.

So, the last part of your question, visibility in Q4, as of right now I think our confidence level for I'm going to say it in a very odd way, unanticipated but now predicted early payoffs are somewhere in the neighborhood around $50 million to $70 million. That could change materially up or down by $20 million only because I am aware of four companies that are actively engaged in M&A discussions that if they do occur that will make the number in the high end of the range and if they don' occur that will put it down in the lower end of the range. So, that's one of the problems that we always have is trying to handicap where exactly are we in the continuum of these early payoff activities.

That's helpful. So, if I, I guess to clarify, hear you correct, Q4, based on your margin commentary that you did, you kind of hit the core level of margin that you'd expect to resume at a stable level from there and that Q4 would see us return to the kind of portfolio growth you experienced in the first half of the year. Is that kind of a fair way to think about the near-term here?

Absolutely. I think you will see portfolio growth in Q4 in the neighborhood of maybe $100 million to $120 million net plus that we're forecasting in the portfolio in Q4. You then -- I don't expect to see our yields or effective yields to sustain the level of 16% because of the early payoff activities that took place in Q3. So, we do expect a more modest early repayment activities by more mature companies being later stage companies that are now in probably month 20 or beyond.

So, you're not going to see the large impact from both fee acceleration as well as prepayment penalties kicking in. You'll see a continuous separation of core yields to effective yields but I think effective yields modulate downward a bit in Q4. The level, it's unclear right now because we're still actually trying to figure out which loan, the ones we're going to pay off, again subject to them paying off or not, and so I think that could certainly looking at yields at the 13.5 to 14.5 is probably the right range to look at.

Okay. Thanks very much. And final question, you've given us a lot of updates on the competitive environment and there has been volatility in the equity markets. It's certainly bled over into some of the high yield markets. How do you view the competitive market? I guess maybe particularly your ability to capture some decent warrants and new deployments because I know you've mentioned it was -- equity values were getting higher. Are they changing now? Is it giving you guys more opportunity?

I think the equity valuations in the private sector remain at elevated levels. I do expect some time in the first half of '15 to probably see some gradual pull back on private company valuations and clearly with $300 million of available liquidity to invest we certainly expect to take advantage of that. And bring on board more attractively the price warrants that may offer better upside than you otherwise would see in the near-term.

And so I think that the portfolio will benefit from the eventuality of valuation adjustment because we're coming in with debt, with warrants and we can actually reprice those warrants to different matrixes to give us advantage or better upside, total return potential.

Thanks very much, guys.

Thank you.

Vernon Plack, BB&T Capital Markets.

Thanks very much. Manuel, while you addressed most of my primary questions in your response to John just a second ago, looking at the -- I'm curious in terms of should we see any further reduction in your available and unencumbered commitments from the $110 million range that you just reported?

You will continue to see lesser of an extreme reduction in Q4 but a continued reduction in Q4 as we both convert unfunded commitments and new funded assets as well as we -- the company doesn't achieve expected milestones in Q4. That in itself naturally will cause some of those unfunded commitments to lapse and not be available. So, the combination of those two, yes. We do expect continued contraction and unfunded commitments but not to the extreme that we saw in Q2 to Q3.

Great. And the G&A line in the P&L, I know this quarter was about $4.5 million I think. Is that a good run rate going forward?

Yes. I can address that. This is Mark. It's the run rate that we currently have based on the activity that was going on within the quarter, the growth, et cetera. I would tell you that that number probably would decrease a little bit in Q4 and that would probably be more of a normalized rate. But I do want to kind of caution that clearly as we continue to grow I think that assumption through 2016, et cetera, then yes, the answer would be it should grow in line with revenue.

Vernon, a lot of the G&A in Q3 had final payments on executive search firms that we were using, running of course. We've been making some hires, some of which we'll be announcing here hopefully in the next week or two but we have been very active also in adding to our organization as you may realize we just recently opened an office in LA. We are expanding in other areas, in other markets, and we're also augmenting both our East Coast and West Coast team with some extremely high caliber new investment professionals that we just added or will soon be added to the organization further driving further growth of earnings and assets for our shareholders.

Great. And just one quick follow up. What is your FTE count right now? And what are you trying to grow that too?

We're approximately at 62. And that will probably grow to mid-70s by most likely second half of '16. We're slow to hire because it's just like we invest. We take time to make sure we understand the people.

Okay. Great. Thank you very much.

Chris York, JMP Securities.

Good afternoon. My first question kind of dovetails with Vernon's question. So, Manuel, you recently opened up and you talked about your LA office, some other remote offices. I'd like to hear about the production and how it's been at some of those offices. And then more specifically, origination activity away from the Valley.

It's not away from the Valley. We're extremely busy in the Valley. But what we realized is that we were spending too much time in airplanes servicing the calls and the needs of those new emerging markets, that venture capital activity. LA is actually representing a very strong social media, gaming marketplace that we are quite optimist about.

So, we're seeing a growing demand of capital in that market and as we always prefer to do at Hercules, we actually prefer to have physical presence in the market that we're involved in. And I think Hercules now has offices in -- actually larger than any other venture lender out there. But we have offices in Boston, obviously, Palo Alto, LA, Washington DC, and McLean, Virginia, Philadelphia, New York, and Chicago.

And that really gives us a very strong footprint into canvassing all the critical venture capital centers in the country. We're well positioned in that area. As to productivity, we think that an office over time should generate over $100 million in new loan origination on an annual basis if not more as we add more staff to it. But that's typically what we look to.

Since some of those remote offices are new, I would suspect that they're not at that level. Should we expect a greater contribution maybe first half of '16?

It typically takes us nine months to a year to have a new hire conditioned to the Hercules underwriting paradigm. We prefer not to rush. We make investments and we care about the outcome of those investments, not market share. And so we're very much focused on the fundamentals of underwriting and identifying the right companies. We simply aren't rushing to put money to work. So, that's why we give our individual new hires anywhere between six to nine months to get conditioned and become productive. That is exactly the timeframe you referred to. Sometime in the second half of '16, you start seeing that productivity really start kicking in.

Got it. Makes sense. Then, lastly here, I'd like to have you elaborate potentially more on your prepared comments for support and interest in BDC M&A. If you found a target you were interested in, would you consider taking the strategy similar to another BDC that is involved in potential M&A by acquiring shares in the open market? Or what other route would you consider?

You know, it's our preference to always do transactions on a friendly basis and partner together as opposed to a hostile transaction. But as we're seeing in the marketplace I think there is a -- two different approaches going on right now. I think we just want to watchfully wait. What is going on? We're not in any urgency to do anything. It's something that's probably more of a tertiary strategy than a primary strategy. Definitely more opportunistic than anything else. I think we are successfully enough in our business and busy enough in our business that if an opportunity presents itself that's attractive and it's really friendly, I think we would pursue it. And that's my first choice in doing any transaction.

Got it. That's it for me. Thanks, guy.

Thank you.

Douglas Harter, Credit Suisse.

Hi. This is Sam Choe filling in for Doug Harter. Our questions have been answered. Thank you.

(Operator Instructions) Jonathan Bock, Wells Fargo.

Hi, guys. Thank you. It's actually Finn O'Shea here for Jon Bock. Sorry about that. First question, you mentioned you're going to take down more of the I believe it was the 7% 2019 notes. How should we look at your liability going forward as a split between revolver and term debt. Is this going to be replaced with a cheaper term debt or the bank facility?

Let me try to answer that for you, obviously one is without thought of the other in the sense that when we reduce the 2019 7% notes by $40 million, as I articulated into the conversation, there's good savings involved and that's accretive, obviously, over to the P&L. We're always trying to go sub-5% on our average weighted cost of debt. So, now that we have an effective shelf registry, we'll be looking externally to see what options we have there in the public debt markets.

(inaudible) to the credit facilities that we have, we use those as you can imagine to assist us with our cash drag, that is right now you can see the liquidity we have at the end of the quarter. As we front new investments we will start drawing back down on to the facility when the facility sizes start to aggregate in value then we will look back into the debt markets and replace that with another long-term debt product and then keep recycling as we see fit to minimize cash drag as much as possible.

Finn, as I said historically, I don't like having more than 20%, 25% of our capitalization be on short-term bank lines. I think that will continue to manage the business to some of that level. It's clearly my preference to continuously leg out maturities of bonds and mitigate any debt maturity walls that come up and that's one of the reasons why we're proactively also looking to push out and restructure some of our credit liabilities. Also a reminder that our convertible bonds, the last remaining tail that is mature in April of 2016 and that will clean up any remaining legacy convertible bond as well.

Very well. Thank you. And on fundings this quarter, do you have a number? Even a ballpark number? Fundings that were new at the time originations versus prior commitments?

I don't think we have that allocation in front of us but I think you're safe to assume that Q4 you'll probably look at gross fundings allocated probably -- are you talking about Q3 or Q4? Sorry.

Q3.

Sorry. Q3. I think Mark might actually have Q3 data.

Yeah. I think the easiest way to describe is of the $157 million we had it's about a 50-50 in terms of between the new loans and existing loans. So, it's still pretty consistent in terms of what we were discussing on the new companies which is funding the existing companies.

Okay. Very well. That's all for me. Thank you.

Thank you.

Ryan Lynch, KBW.

Good afternoon. Thanks for taking my questions. It looks like you guys had about $35 million uptick in investments that are listed as grade five in the quarter. And it also looks like you guys had about $1 million of collateral based impairment write downs in the quarter. I just would've expected more collateral write downs in the quarter given the move, the decent size of new grade five investments. So, can you just help me understand why there were so little collateral based write downs in the quarter?

Sure. As they said, I have four companies that have signed -- excuse me, four companies who are in the midst and throes of completing a M&A event. Without getting into specific names, some of those names may be reflective in a rated four or rated five and we do that because such time as our companies have secured subsequent round of financing that will fund them through the operation of the business for the next 9 to 12 months, until that is completed we take the cautionary approach to merely mark it down to signal that we are monitoring the situation closely and oftentimes the case is because there's an abundance of enterprise value to cover our loan, that would mitigate any need or necessity to then mark down the credit or mark down the loan in that context.

So, just because the rate is five does not directly correlate that there has to be an impairment of principle or loan value against the credit. If the credit were to deteriorate further, meaning that a M&A event that pursuantly not completed and subsequently not followed up by an equity infusion by the venture capital firms, that would merit a revisit of the credit rating on that credit or the impairment on that credit but at this juncture, given that many of our companies are very actively involved in M&A discussions to which we are very much aware of, we don't see at this juncture any necessity to impair principle risk.

Okay. Great. And then you guys have a nice job of reducing unfunded commitments over the past few quarters. You also talked about reducing -- actively reducing some specific exposures like you exposure to China in the most recent quarter. I was just curious if any of the repayments in the current quarter were initiated by you guys in an effort to reduce any associated unfunded commitments with a specific portfolio company?

The answer to that question is obviously yes. As Hercules has done throughout its many years in history in monitoring credit, we take a very proactive approach to looking at credit, not necessarily in the current quarter, but what is the occurrence of a credit situation two or three quarters out. And that has served us well over the years.

Yes, it may hurt that I may give up some current interest income but I also mitigate the possibility of principle risk two or three quarters later on down the road. So, we actually had to take a proactive approach in the portfolio valuation in Q3 and we identified those companies that we felt had a disproportionate risk to a China pullback. And we had taken the effort to reduce that risk and part of that risk has manifested itself in the $190 million of early loan payoffs.

So, yes, we do that from time to time. China is one of those issues. We also have another situation I don't want to disclose so I don't give some of our competitors the clue but there's another sector that we have made a conscious effort to pull back some as well while some of our competitors are gleefully looking for a way in and we're fine with that.

All right. Great. That's all from me.

Aaron Deer, Sandler O'Neill & Partners.

Hey, good afternoon, everyone. Just one quick follow up question for me on the unfunded commitments. I'm just curious if there's been any shift in how you're underwriting credit or the structure of the credits that's bringing down the level of unfunded commitments or contributing to it anyway?

So, obviously new credit origination will not impact legacy unfunded commitments but the answer to your question is yes. We have made materially changes to our business that would absolutely ensure that the unfunded commitments continue to decline over time. As you saw, with our ability to originate in Q3, we're not seeing any impact to our business because thankfully the SEC has applied the methodology system wide so others will have to calibrate the same thing that we're doing anyway.

So, we know impact to our business on a go forward basis and we are actively, as we said at the beginning of the call, a lot of the unfunded commitments converted into funded assets as well as a portion of those unfunded commitments expired merely due to the passage of time or the milestones that the company anticipated hitting were not achieved. Those two factors certainly helped relieve or reduce the unfunded commitments. So, we expect to see further decline in Q4.

So, what are the material changes that were made on new credits versus the legacy stuff?

I'm sorry, we're not going to disclose because that's competitive advantage. But the answer is that we are and we are not going to get into the specifics as to how we conduct our business and divulge trade secrets on these calls.

Fair enough. Thanks for taking my questions.

Leslie Vandegrift, Raymond James.

Hi, guys. It's Leslie Vandegrift. How are you doing today?

Good. Thank you. How are you?

Doing well, thanks. I've got a couple of just kind of tied together questions. First of all, you were talking about possible BDC M&A interest. I know right now we're all kind of watching to see how that current news story goes but if you were interested in looking for any sort of qualities you were looking for, an expansion of our current -- the same kinds of loans you currently do, expansion into maybe a different area of the middle market? Any color on that would be great.

I'm sure you would like color on that. Clearly we're not going to disclose that. I think that like you, we're watching the developments in the BDC industry. There are certainly larger BDCs than us that I'm very much aware who are closely scrutinizing and monitoring the business. I think this gives managers the opportunity to readjust their management fees if they so chose.

But I think right now we're all watching and waiting the current development, if not saga, that's taking place in the market and see how that comes out and see which processes tend to be viewed more favorable and what tend to be viewed less favorable. I think that we're patient and like I said it's a tertiary part of our strategy, not primary. If we don't do anything for six months or a year, that's fine as well. It's much more of an opportunistic and as I said at the beginning of the call, I prefer to have it done on a friendly basis in a very collaborative basis than a hostile basis.

Of course. Yes. Okay. And then on funding commitments, I know we talked about it a lot this call and you guys have been taking it down. Any response in the SEC? I know that obviously your mixed security shelf got filed and was effective before filing your 10-Q, so that's through. But I've seen a lot of other BDCs have correspondence come out publically where they're responding back and forth with the SEC. Have you guys had that? And if so, color around their response to your differentiation between milestone versus not milestone -- unfunded commitments?

I'll let Mark answer that but you're absolutely right. I think the first wave of BDCs who were eager to put this situation behind them were engaged and very open, open comment letters back and forth with the SEC. We certainly opted to go and engage proactively with the SEC on a more private basis which Mark can kind of opine and give you more color on the current developments and final conclusions from the SEC. Mark?

Sure. Look, the SEC, as I've discussed before, when we first began this process we had some comment letters go back and forth. I think one of the more interesting parts that we did was really sit down with the Securities and Exchange Commission on a phone call for about 1.5 hours, walking them through not just the BDC space which I think everybody generalizes a bit too much, but that we're a venture debt, how our unfunded commitments are potentially different to mid- and low market lenders, et cetera, et cetera.

And it was a very meaningful discussion. We followed up that up with a letter, just this is rearticulating the points that we made. We had some good conversations back and forth. And again we weren't surprised at all in terms of how it all came out. That was what we were expecting or at least hoping and expecting. And so it all worked out very well. It was very proactive, very meaningful discussions.

In terms of your kind of first point which is the available and unavailable milestone basis, yes. We had discussions around that. They I think had a much better appreciation of one being openly contractually an obligation versus one is not. The hurdle rates for those that were not achieving their milestones yet, and the way that we manage our balance sheet is incredibly consistent and our ability which is why I was personally very pleased with the representation in essence basically saying that we'll be careful and monitor our unfunded with our balance sheet which of course we would do. So, I hope that helps you in terms of where we got to with them.

Definitely. It's good. The last question, I know you guys are talking about the market outlook seems pretty positive on your end, kind of all around for fourth quarter. But we've heard other peers, even some of the banks, the Silicon Valley Bank had issues in the third quarter, talking about the VC market maybe being a little bit slow over the next few quarters. Obviously you guys aren't seeing that. Do you know of any reason why maybe you guys are seeing better deals, more deals coming through, any differentiation there?

Silicon Valley Bank is a good quality name. And they're very large in the asset class. But they're a bank. They focus on customers and deposits. We focus on making investment in prudent later stage companies that approaching greater liquidity events. So, I think that we basically fish in two different types of areas. With pull back in valuations that we expect to see occurring in Q4 and the first half of '15, excuse me, the first half of '16, I think debt is a natural product that can help stem the dilutive impact on a lower valuation.

And that requires you to be able to do larger transaction sizes to which Hercules' balance sheet lends itself very favorable to while others don't have the wherewithal and balance sheet to do a $30 million, $40 million, $50 million transaction as we can.

So, I think that a differentiation in a market will become very clear in Q4 and the first half of '15, those with capital and those without capital to be able to benefit themselves on those larger transactions that we think will come to the table which is why we're pretty excited about our liquidity position where we're at and the opportunities that we see before us with $300 million of available dry powder to invest. So, we actually think Q4 and the first half of '16 are going to be quite attractive periods.

Perfect. That's it for me. Thank you.

Thank you very much.

Thank you. At this time I'm not showing any further questions. I would like to turn the call back over to Manuel Henriquez. You may proceed.

Thank you, Operator. Thank you, everyone, for joining on the call today. As most of you may be aware, we are attending the Wells Fargo BDC conference in New York on November 17th to the 18th. We have a very, very busy schedule already on that date with many investor meetings but clearly if you want to put your name on that list and have a meeting with management I would encourage you to reach out, please, to our Investor Relations department, Michael Hara, he will help coordinate a time slot if available or a meeting if you're in New York while we're there as well. Thank you, everybody. Operator, that concludes the call.

Thank you. Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a great day.